Excerpt: House of Debt

A SCANDAL IN BOHEMIA

Selling recreational vehicles used to be easy in America. As a button worn by Winnebago CEO Bob Olson read, “You can’t take sex, booze, or weekends away from the American people.” But things went horribly wrong in 2008, when sales for Monaco Coach Corporation, a giant in the RV industry, plummeted by almost 30 percent. This left Monaco management with little choice. Craig Wanichek, their spokesman, lamented, “We are sad that the economic environment, obviously outside our control, has forced us to make . . . difficult decisions.”

Monaco was the number-one producer of diesel-powered motor homes. They had a long history in northern Indiana making vehicles that were sold throughout the United States. In 2005, the company sold over 15,000 vehicles and employed about 3,000 people in Wakarusa, Nappanee, and Elkhart Counties in Indiana. In July 2008, 1,430 workers at two Indiana plants of Monaco Coach Corporation were let go. Employees were stunned. Jennifer Eiler, who worked at the plant in Wakarusa County, spoke to a reporter at a restaurant down the road: “I was very shocked. We thought there could be another layoff, but we did not expect this.” Karen Hundt, a bartender at a hotel in Wakarusa, summed up the difficulties faced by laid-off workers: “It’s all these people have done for years. Who’s going to hire them when they are in their 50s? They are just in shock. A lot of it hasn’t hit them yet.”

In 2008 this painful episode played out repeatedly throughout northern Indiana. By the end of the year, the unemployment rate in Elkhart, Indiana, had jumped from 4.9 to 16.2 percent. Almost twenty thousand jobs were lost. And the effects of unemployment were felt in schools and charities throughout the region. Soup kitchens in Elkhart saw twice as many people showing up for free meals, and the Salvation Army saw a jump in demand for food and toys during the Christmas season. About 60 percent of students in the Elkhart public schools system had low-enough family income to qualify for the free-lunch program.

Northern Indiana felt the pain early, but it certainly wasn’t alone. The Great American Recession swept away 8 million jobs between 2007 and 2009. More than 4 million homes were foreclosed. If it weren’t for the Great Recession, the income of the United States in 2012 would have been higher by $2 trillion, around $17,000 per household. The deeper human costs are even more severe. Study after study points to the significant negative psychological effects of unemployment, including depression and even suicide. Workers who are laid off during recessions lose on average three full years of lifetime income potential. Franklin Delano Roosevelt articulated the devastation quite accurately by calling unemployment “the greatest menace to our social order.”

Just like workers at the Monaco plants in Indiana, innocent bystanders losing their jobs during recessions often feel shocked, stunned, and confused. And for good reason. Severe economic contractions are in many ways a mystery. They are almost never instigated by any obvious destruction of the economy’s capacity to produce. In the Great Recession, for example, there was no natural disaster or war that destroyed buildings, machines, or the latest cutting-edge technologies. Workers at Monaco did not suddenly lose the vast knowledge they had acquired over years of training. The economy sputtered, spending collapsed, and millions of jobs were lost. The human costs of severe economic contractions are undoubtedly immense. But there is no obvious reason why they happen.

Intense pain makes people rush to the doctor for answers. Why am I experiencing this pain? What can I do to alleviate it? To feel better, we are willing to take medicine or change our lifestyle. When it comes to economic pain, who do we go to for answers? How do we get well? Unfortunately, people don’t hold economists in the same esteem as doctors. Writing in the 1930s during the Great Depression, John Maynard Keynes criticized his fellow economists for being “unmoved by the lack of correspondence between the results of their theory and the facts of observation.” And as a result, the ordinary man has a “growing unwillingness to accord to economists that measure of respect which he gives to other groups of scientists whose theoretical results are confirmed with observation when they are applied to the facts.”

There has been an explosion in data on economic activity and advancement in the techniques we can use to evaluate them, which gives us a huge advantage over Keynes and his contemporaries. Still, our goal in this book is ambitious. We seek to use data and scientific methods to answer some of the most important questions facing the modern economy: Why do severe recessions happen? Could we have prevented the Great Recession and its consequences? How can we prevent such crises? This book provides answers to these questions based on empirical evidence. Laid-off workers at Monaco, like millions of other Americans who lost their jobs, deserve an evidence-based explanation for why the Great Recession occurred, and what we can do to avoid more of them in the future.

Whodunit?

In “A Scandal in Bohemia,” Sherlock Holmes famously remarks that “it is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts.”6 The mystery of economic disasters presents a challenge on par with anything the great detective faced. It is easy for economists to fall prey to theorizing before they have a good understanding of the evidence, but our approach must resemble Sherlock Holmes’s. Let’s begin by collecting as many facts as possible.

Figure 1.1: U.S. Household Debt-to-Income Ratio

When it comes to the Great Recession, one important fact jumps out: the United States witnessed a dramatic rise in household debt between 2000 and 2007—the total amount doubled in these seven years to $14 trillion, and the household debt-to-income ratio skyrocketed from 1.4 to 2.1. To put this in perspective, figure 1.1 shows the U.S. household debt-to-income ratio from 1950 to 2010. Debt rose steadily to 2000, then there was a sharp change.

Using a longer historical pattern (based on the household-debt-to-GDP [gross domestic product] ratio), economist David Beim showed that the increase prior to the Great Recession is matched by only one other episode in the last century of U.S. history: the initial years of the Great Depression. From 1920 to1929, there was an explosion in both mortgage debt and installment debt for purchasing automobiles and furniture. The data are less precise, but calculations done in 1930 by the economist Charles Persons suggest that outstanding mortgages for urban nonfarm properties tripled from 1920 to 1929. Such a massive increase in mortgage debt even swamps the housing-boom years of 2000–2007.

The rise in installment financing in the 1920s revolutionized the manner in which households purchased durable goods, items like washing machines, cars, and furniture. Martha Olney, a leading expert on the history of consumer credit, explains that “the 1920s mark the crucial turning point in the history of consumer credit.” For the first time in U.S. history, merchants selling durable goods began to assume that a potential buyer walking through their door would use debt to purchase. Society’s attitudes toward borrowing had changed, and purchasing on credit became more acceptable.

With this increased willingness to lend to consumers, household spending in the 1920s rose faster than income. Consumer debt as a percentage of household income more than doubled during the ten years before the Great Depression, and scholars have documented an “unusually large buildup of household liabilities in 1929.” Persons, writing in 1930, was unambiguous in his conclusions regarding debt in the 1920s: “The past decade has witnessed a great volume of credit inflation. Our period of prosperity in part was based on nothing more substantial than debt expansion.” And as households loaded up on debt to purchase new products, they saved less. Olney estimates that the personal savings rate for the United States fell from 7.1 percent between 1898 and 1916 to 4.4 percent from 1922 to 1929.

So one fact we observe is that both the Great Recession and Great Depression were preceded by a large run-up in household debt. There is another striking commonality: both started off with a mysteriously large drop in household spending. Workers at Monaco Coach Corporation understood this well. They were let go in large part because of the sharp decline in motor-home purchases in 2007 and 2008. The pattern was widespread. Purchases of durable goods like autos, furniture, and appliances plummeted early in the Great Recession—before the worst of the financial crisis in September 2008. Auto sales from January to August 2008 were down almost 10 percent compared to 2007, also before the worst part of the recession or financial crisis.

The Great Depression also began with a large drop in household spending. Economic historian Peter Temin holds that “the Depression was severe because the fall in autonomous spending was large and sustained,” and he remarks further that the consumption decline in 1930 was “truly autonomous,” or too big to be explained by falling income and prices. Just as in the Great Recession, the drop in spending that set off the Great Depression was mysteriously large.

The International Evidence

This pattern of large jumps in household debt and drops in spending preceding economic disasters isn’t unique to the United States. Evidence demonstrates that this relation is robust internationally. And looking internationally, we notice something else: the bigger the increase in debt, the harder the fall in spending. A 2010 study of the Great Recession in the sixteen OECD (Organisation for Economic Co-operation and Development) countries by Reuven Glick and Kevin Lansing shows that countries with the largest increase in household debt from 1997 to 2007 were exactly the ones that suffered the largest decline in household spending from 2008 to 2009 . The authors find a strong correlation between household debt growth before the downturn and the decline in consumption during the Great Recession. As they note, consumption fell most sharply in Ireland and Denmark, two countries that witnessed enormous increases in household debt in the early 2000s. As striking as the increase in household debt was in the United States from 2000 to 2007, the increase was even larger in Ireland, Denmark, Norway, the United Kingdom, Spain, Portugal, and the Netherlands. And as dramatic as the decline in household spending was in the United States, it was even larger in five of these six countries (the exception was Portugal).

A study by researchers at the International Monetary Fund (IMF) expands the Glick and Lansing sample to thirty-six countries, bringing in many eastern European and Asian countries, and focuses on data through 2010. Their findings confirm that growth in household debt is one of the best predictors of the decline in household spending during the recession. The basic argument put forward in these studies is simple: If you had known how much household debt had increased in a country prior to the Great Recession, you would have been able to predict exactly which countries would have the most severe decline in spending during the Great Recession.

But is the relation between household-debt growth and recession severity unique to the Great Recession? In 1994, long before the Great Recession, Mervyn King, the recent governor of the Bank of England, gave a presidential address to the European Economic Association titled “Debt Deflation: Theory and Evidence.” In the very first line of the abstract, he argued: “In the early 1990s the most severe recessions occurred in those countries which had experienced the largest increase in private debt burdens.” In the address, he documented the relation between the growth in household debt in a given country from 1984 to 1988 and the country’s decline in economic growth from 1989 to 1992. This was analogous to the analysis that Glick and Lansing and the IMF researchers gave twenty years later for the Great Recession. Despite focusing on a completely different recession, King found exactly the same relation: Countries with the largest increase in household-debt burdens—Sweden and the United Kingdom, in particular—experienced the largest decline in growth during the recession.

Another set of economic downturns we can examine are what economists Carmen Reinhart and Kenneth Rogoff call the “big five” postwar banking crises in the developed world: Spain in 1977, Norway in 1987, Finland and Sweden in 1991, and Japan in 1992. These recessions were triggered by asset-price collapses that led to massive losses in the banking sector, and all were especially deep downturns with slow recoveries. Reinhart and Rogoff show that all five episodes were preceded by large run-ups in real-estate prices and large increases in the current-account deficits (the amount borrowed by the country as a whole from foreigners) of the countries.

But Reinhart and Rogoff don’t emphasize the household-debt patterns that preceded the banking crises. To shed some light on the household-debt patterns, Moritz Schularick and Alan Taylor put together an excellent data set that covers all of these episodes except Finland. In the remaining four, the banking crises emphasized by Reinhart and Rogoff were all preceded by large run-ups in private-debt burdens. (By private debt, we mean the debt of households and non-financial firms, instead of the debt of the government or banks.) These banking crises were in a sense also privatedebt crises—they were all preceded by large run-ups in private debt, just as with the Great Recession and the Great Depression in the United States. So banking crises and large run-ups in household debt are closely related—their combination catalyzes financial crises, and the groundbreaking research of Reinhart and Rogoff demonstrates that they are associated with the most severe economic downturns.18 While banking crises may be acute events that capture people’s attention, we must also recognize the run-ups in household debt that precede them.

Which aspect of a financial crisis is more important in determining the severity of a recession: the run-up in private-debt burdens or the banking crisis? Research by Oscar Jorda, Moritz Schularick, and Alan Taylor helps answer this question. They looked at over two hundred recessions in fourteen advanced countries between 1870 and 2008 They begin by confirming the basic Reinhart and Rogoff pattern: Banking-crisis recessions are much more severe than normal recessions. But Jorda, Schularick, and Taylor also find that banking-crisis recessions are preceded by a much larger increase in private debt than other recessions. In fact, the expansion in debt is five times as large before a banking-crisis recession. Also, banking-crisis recessions with low levels of private debt are similar to normal recessions. So, without elevated levels of debt, banking-crisis recessions are unexceptional. They also demonstrate that normal recessions with high private debt are more severe than other normal recessions. Even if there is no banking crisis, elevated levels of private debt make recessions worse. However, they show that the worst recessions include both high private debt and a banking crisis.20 The conclusion drawn by Jorda, Schularick, and Taylor from their analysis of a huge sample of recessions is direct:

We document, to our knowledge for the first time, that throughout a century or more of modern economic history in advanced countries a close relationship has existed between the build-up of credit during an expansion and the severity of the subsequent recession. . . . [W]e show that the economic costs of financial crises can vary considerably depending on the leverage incurred during the previous expansion phase [our emphasis].

Taken together, both the international and U.S. evidence reveals a strong pattern:Economic disasters are almost always preceded by a large increase in household debt. In fact, the correlation is so robust that it is as close to an empirical law as it gets in macroeconomics. Further, large increases in household debt and economic disasters seem to be linked by collapses in spending.

So an initial look at the evidence suggests a link between household debt, spending, and severe recessions. But the exact relation between the three is not precisely clear. This allows for alternative explanations, and many intelligent and respected economists have looked elsewhere. They argue that household debt is largely a sideshow—not the main attraction when it comes to explaining severe recessions.

The Alternative Views

Those economists who are suspicious of the importance of household debt usually have some alternative in mind. Perhaps the most common is the fundamentals view, according to which severe recessions are caused by some fundamental shock to the economy: a natural disaster, a political coup, or a change in expectations of growth in the future.

But most severe recessions we’ve discussed above were not preceded by some obvious act of nature or political disaster. As a result, the fundamentals view usually blames a change in expectations of growth, in which the run-up in debt before a recession merely reflects optimistic expectations that income or productivity will grow. Perhaps there is some technology that people believe will lead to huge improvements in well-being. Severe recession results when these high expectations are not realized. People lose faith that technology will advance or that incomes will improve, and therefore they spend less. In the fundamentals view, debt still increases before severe recessions. But the correlation is spurious—it is not indicative of a causal relation.

A second explanation is the animal spirits view, in which economic fluctuations are driven by irrational and volatile beliefs. It is similar to the fundamentals view except that these beliefs are not the result of any rational process. For example, during the housing boom before the Great Recession, people may have irrationally thought that house prices would rise forever. Then fickle human nature led to a dramatic revision of beliefs. People became pessimistic and cut back on spending. House prices collapsed, and the economy went into a tailspin because of a self-fulfilling prophecy. People got scared of a downturn, and their fear made the downturn inevitable. Once again, in this view household debt had little to do with the ensuing downturn. In both the fundamentals and animal spirits mind-sets, there is a strong sense of fatalism: a large drop in economic activity cannot be predicted or avoided. We simply have to accept them as a natural part of the economic process.

A third hypothesis often put forward is the banking view, which holds that the central problem with the economy is a severely weakened financial sector that has stopped the flow of credit. According to this, the run-up in debt is not a problem; the problem is that we’ve stopped the flow of debt. If we can just get banks to start lending to households and businesses again, everything will be all right. If we save the banks, we will save the economy. Everything will go back to normal.

The banking view in particular enjoyed an immense amount of support among policy makers during the Great Recession. On September 24, 2008, President George W. Bush expressed his great enthusiasm for it in a hallmark speech outlining his administration’s response. As he saw it, “Financial assets related to home mortgages have lost value during the house decline, and the banks holding these assets have restricted credit. As a result, our entire economy is in danger. . . . So I propose that the federal government reduce the risk posed by these troubled assets and supply urgently needed money so banks and other financial institutions can avoid collapse and resume lending. . . . This rescue effort . . . is aimed at preserving America’s overall economy.” If we save the banks, he argued, it would help “create jobs” and it “will help our economy grow.” There’s no such thing as excessive debt—instead, we should encourage banks to lend even more.

* * *

The only way we can address—and perhaps even prevent—economic catastrophes is by understanding their causes. During the Great Recession, disagreement on causes overshadowed the facts that policy makers desperately needed to clean up the mess. We must distinguish whether there is something more to the link between household debt and severe recessions or if the alternatives above are true. The best way to test this is the scientific method: let’s take a close look at the data and see which theory is valid. That is the purpose of this book.

To pin down exactly how household debt affects the economy, we zero in on the United States during the Great Recession. We have a major advantage over economists who lived through prior recessions thanks to the recent explosion in data availability and computing power. We now have microeconomic data on an abundance of outcomes, including borrowing, spending, house prices, and defaults. All of these data are available at the zip-code level for the United States, and some are available even at the individual level. This allows us to examine who had more debt and who cut back on spending—and who lost their jobs.

The Big Picture

As it turns out, we think debt is dangerous. If this is correct, and large increases in household debt really do generate severe recessions, we must fundamentally rethink the financial system. One of the main purposes of financial markets is to help people in the economy share risk. The financial system offers many products that reduce risk: life insurance, a portfolio of stocks, or put options on a major index. Households need a sense of security that they are protected against unforeseen events.

A financial system that thrives on the massive use of debt by households does exactly what we don’t want it do—it concentrates risk squarely on the debtor. We want the financial system to insure us against shocks like a decline in house prices. But instead, as we will show, it concentrates the losses on home owners. The financial system actually works against us, not for us. For home owners with a mortgage, for example, we will demonstrate how home equity is much riskier than the mortgage held by the bank, something many home owners realize only when house prices collapse.

But it’s not all bad news. If we are correct that excessive reliance on debt is in fact our culprit, it is a problem that potentially can be fixed. We don’t need to view severe recessions and mass unemployment as an inevitable part of the business cycle. We can determine our own economic fate. We hope that the end result of this book is that it will provide an intellectual framework, strongly supported by evidence, that can help us respond to future recessions— and even prevent them. We understand this is an ambitious goal.

But we must pursue it. We strongly believe that recessions are not inevitable—they are not mysterious acts of nature that we must accept. Instead, recessions are a product of a financial system that fosters too much household debt. Economic disasters are man-made, and the right framework can help us understand how to prevent them.